2012 Fuel Hedging at JetBlue Airways – Case Solution

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2012 Fuel Hedging at JetBlue Airways Case Answers

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1. Introduction – 2012 Fuel Hedging at JetBlue Airways Case Study

During a lifetime of a business, many different risks could affect its overall value. Companies use insurance to protect themselves against unlikely events that could affect the value of their assets.

These losses in value are derived from damaging hazards such as catastrophes outside their ordinary course of business. Together, firms face many other dangers as part of their business operations (Berk & DeMarzo, 2011).

Corporations implement risk management skills to protect against corporate value-decreasing exposures, such as currency exchange rates, interest rates, and commodity prices; therefore, they increase their corporate market value.

For companies such as JetBlue Airways, excess volatility in the costs of the commodities they use and/or products can be the highest cause of risk to their profitability.

According to Matos (2017) JetBlue, the purchase of jet fuel represents almost 40% of the total operating expenses. To secure from these risks, the financial market provides multiple different instruments for hedging. Hedging involves contracts or transactions that provide the firm with cash flows that offset its losses from price changes (Berk & DeMarzo, 2011).

The purpose of this report is to advise JetBlue on its hedging strategy by looking at the current trend in the oil commodity-related prices and the value-adding that hedging could provide to JetBlue Airways’ market value. The remainder of the report proceeds as follows.

Section II introduces the theory of hedging and explains what futures and forwards are as hedging contracts. Section III discusses in detail if JetBlue should hedge in the following expected year of the case: 2012.

Moreover, as an analysis, the correlation of different oil commodities is shown together with a back-test on the profit and loss from different hedging scenarios. Also, the JetBlue Airways time series before and after the hedges graphs are shown. Section IV compares the literature on corporate finance risk management with this case. Finally, section V concludes.

2. Hedging Theory

Hedging is a critical strategy to implement for listed companies for several reasons. It’s challenging to play out hedging strategies for all the possible risks deriving from reasonably significant business activity.

However, it is fundamental to protect the core business of a company by momentary speculation opportunities. For a company like those, opportunities are mainly derived from certain commodities, which are physiologically necessary for the operating practice. But risks to hedge for a company also come from foreign currencies exchange rates or interest rates. Swings in prices of those mentioned commodities could indeed represent a loss in the value of the assets, which JetBlue Airways cannot ignore.

Companies should also decide to assume hedge positions towards the core risks of their business to protect their investors. Shareholders, who could also consider a hedge position on their own, could not have the necessary information about risks faced by the company, or just the financial knowledge required to implement such an exceptional investment strategy.

Also, transaction costs represent quite a high barrier for the single investor to hedge their risk exposure privately. All these elements make the hypothesis of self-hedging shareholders impossible in fact.

However, the main reason managers should hedge is that lowering the idiosyncratic risk of the company is a necessity they need to supply, providing several benefits the company should not go without, in terms of risk transfer to better bearers.

In particular, categories of risk like the product or geographic risk, which an average investor could be easily protected from by an essential portfolio diversification, could represent a significant menace to a company. Finally, lowering the company’s tax liability could be a determinant factor for a manager to decide to hedge some of the core risks since insurance premiums are often tax-deductible.

Hedging aims to reduce the company’s inertia towards fluctuations in commodities prices, decreasing the risk associated with such fluctuations, and trying to fix a stable value to account for those assets. This technique is implemented in purchasing term contracts whose value is negatively correlated with commodity prices they are hedging from.

The basis is the difference between the spot price of the underlying commodity and the cost of term contracts. They do not necessarily vary by the same amount, so this difference (the basis indeed) may enhance or decrease, causing variable gains or losses depending on the hedged position.

The uncertainty regarding the value of the basis is defined as basis risk – or hedging risk – which is generally attenuated by computing the optimal variance hedge ratio. This, depending on the relationship between the variations of the two prices, allows us to adjust the hedge position and minimize the basis risk. This operation is called “tailing” and is perpetrated by multiplying the hedge ratio by the daily spot price to the futures price ratio (Hull, 2012).

Forward and Futures

Term contracts are typically divided into futures and forwards. The main difference between them is that futures are standardized and consequently more liquid and tradable on regulated markets.

Forwards contracts show more customized terms (they practically represent private agreements between two parties) and have one settlement date at the end of the contract. The benefit deriving from hedging with forwards is evident that they are less exposed to the mentioned basis risk and don’t need any tailing operation due to their not being marked-to-market (traded and settled daily).

However, being sold over-the-counter, they include high counterparty risk, meaning that the possibility of one of the contractors defaulting is undoubtedly higher than it is for futures, which are somehow guaranteed by the intermediation of clearinghouse institutions (Hull, 2012).

Airline’s Dependency on Jet Fuel Price

Hedging strategies can be carried out quite easily if the asset underlying the term contracts is the same commodity whose price is being hedged. Sometimes it is not possible at all to implement hedging strategies towards commodities that are not directly traded.

In such cases, it is necessary to purchase futures on assets that show a matching negative correlation with the exposure to hedge. When the two assets (the one generating the exposure and the one providing the protection) are different, it is called cross-hedging.

This case about JetBlue Airways applies precisely to the case of airline companies: to hedge themselves from variations in jet fuel prices. They purchase derivatives whose underlying is represented by crude oil indexes. It’s not easy to implement a perfect cross-hedging strategy; however, accurate it could be.

A perfect hedge consists of achieving complete protection from the market risk; this is possible only if the hedge position has an ideal inverse correlation with the price of the asset at issue.

An imperfect hedge may not guarantee the desired stabilizing effect on resources’ prices and still be incredibly expensive. This often led airlines to avoid this insurance on operating costs and expose themselves to the risks of possible market turbulences.

As reported by the Wall Street Journal (2011), airline behavior towards using hedging strategies is very heterogeneous and changes substantially from one to the other. However, every CFO agrees that ignoring the risk inherent in the possibility of a sudden increase in the cost of fuel is as dangerous as the implementation of an “over-hedging” strategy. It aims to speculate on such eventuality.

Another necessary consideration derives from the fact that a rise in fuel prices is often accompanied by a generally positive trend in the whole economic system. This generally represents a partial compensation for the prices increase.

Other ways to stem the enhancement in fuel costs are to increase ticket prices or eliminate less profitable routes. However, the most widespread practice is to employ a strategy of partial hedging, to balance the costs of the fuel price increases and those deriving from the payment of the premium for the insurance.

3. The Year 2012: Hedge or Not to Hedge?

“If we don’t do anything, we are speculating. It is our fiduciary duty to hedge fuel price risk.” 

– Scott Topping, Vice President Treasurer, Southwest Airlines. Retrieved from Carter et al. (2006).

In 2011, the jet fuel consumption of JetBlue accounted for 40% of total operating expenses. Because oil prices were volatile in 2011, the ability to hedge its exposure to oil prices constitutes a fundamental part of JetBlue. Mastering this ability would mean that JetBlue Airways would save significant expenses, therefore benefiting its financial and competing position.

However, cross-hedging is complex and influenced by different factors. On the one hand, the before-mentioned volatility of oil prices makes it difficult to forecast future prices accurately. On the other hand, hedging can be expensive to set up and would include the risk of oil prices falling, and therefore making losses.

Currently, JetBlue hedges 45% of its fuel expenses with different hedging strategies in the fourth quarter (Exhibit 9). According to a Bloomberg report (2012), JetBlue’s major competitors are Alaska Air Group Inc. (50% hedge), American Airlines (52% hedge), Delta Air Lines Inc. (40% hedge), Hawaiian Airlines (56% hedge), Southwest Airlines Co. (hedged), United Continental Holdings Inc. (56%).

The only US company that does not hedge is US Airways Group Inc (Bloomberg, 2012). Thus, because there is significant uncertainty on the volatility of oil prices and most of the competitors also hedge, we answer that we will continue to hedge in 2012.

Although some analysts predict that the oil prices could fall back down soon on a mean-reverting process, JetBlue Airways should not speculate on that. Given that jet fuel costs are hedgeable, airlines with a desire for expansion may find value-adding hedging future purchases of jet fuel.

Carter et al. (2006) show that jet fuel hedging is positively related to airline firm value. According to the authors, the principal benefit of jet fuel hedging by airlines comes from reducing underinvestment costs.

JetBlue Airways showed the skills to adapt its hedging based on the volatility of oil prices (Exhibit 3). JetBlue hedged up to 67% in 2007 preceding the spikes of 2008. In 2009 JetBlue hedged little as 9% when fuel prices went back down.

Overall, we recommend JetBlue decrease the fuel hedging for 2012 slightly. According to Jacobs (2012), jet fuel prices are expected to remain at similar levels as in 2011 in 2012. This gives JetBlue Airways the chance to reduce the expensive hedging costs while still taking advantage of constant jet fuel prices.

One problem persists: on what commodity benchmark should the hedging be based. West Texas Intermediate (WTI) and European benchmark Brent crude (Brent) oil showed concerns about their volatility relative to the oil price.

In 2011, WTI started trading at a discount to Brent due to an oil bottleneck in Cushing, Oklahoma – the physical delivery hub. Jet fuel prices had tracked the price of Brent, instead of WTI, for much of 2011. Therefore, the remaining question is if JetBlue Airways should continue to use WTI as an oil benchmark.

Commodity Correlation with Jet Fuel: 2007 to 2011 period

As to selecting the most appropriate commodity between WTI, Brent, or heating oil as a basis for cross-hedging jet fuel prices, the optimal choice would be the commodity that is most aligned with the actual market prices of jet fuel.

To this purpose, Exhibit 5 Panel 5 comes of use as it illustrates the differences in prices between either commodity in comparison with the prices of jet fuel. To be noticed is that the deviation of WTI (dark blue) in contrast with jet fuel prices (horizontal axis) is the most extreme. The graph line of Brent is more closely aligned with jet fuel prices, whereas the heating oil prices are mostly in line with jet fuel prices.